Kneale: A Fix For Toxic Assets—ETFs!


Anybody out there got the super-secret e-mail address for President Obama, the Blackberry addict? How about a cell-phone number for Treasury Secretary Timothy Geithner? I need to get in touch with them.

The two men are struggling with the linchpin of their rescue plan for the economy: how to rid ailing bank balance sheets of the toxic assets that have sparked a pandemic of fear around the world.

I may have a solution: ETFs. Huh? Yup—Exchange Traded Funds. Turn all those rotting securities into an ETF, add a boost from government and let investors put a real, truly liquid value on 'em.

That fix, from an old friend of mine, is one of hundreds of proposals gestating out there in Main Street America. Oddly and unwisely, since taking office the Obama Administration hasn’t sought the insights of former Treasury Secretary Hank Paulson and his minions. Nor has it asked for advice from the Wall Street masterminds who led us down this tortuous path, though they could help us find our way out.

So maybe Tim and the O-man oughta listen to Joe Sixpack.

The ETF approach comes from a longtime pal, an intrepid trader and financial alchemist we will call "Rob" (Because, um, that's his name).  Rob isn't with some Wall Street goliath that got us into this meltdown. Though he is my age, he retired from a small New York hedge fund over a decade ago to manage his own money.

The Rob Plan is worth a listen because this guy has reaped riches at the intersection of public aid and private profit. In one savvy deal in the early 1990s, he and his partners bought the seemingly worthless toxic paper of a bankrupt S&L from Resolution Trust Corp., the government bailout agency that led us out of that long-ago crisis. They reaped a three-fold gain.

His plan goes like this: The banks pick out their very worst mortgage-backed securities, which threaten some of them with insolvency if they were to mark down this securitized garbage to reflect its true lack of tradable value in this fretful market.

Let’s say the scariest bad stuff has a combined on-the-books value of $1 trillion. All of it goes into a joint central fund, run by a quasi-governmental entity. In return the fund hands out ETFs to the banks, proportionate to the sums they had put in.

The feds then pay the banks a 4 percent annual dividend on the ETFs. This would cost taxpayers $40 billion a year on $1 trillion in bad assets—and pump that sum into the banks that were the sickest from all those silly derivatives.

So the banks' balance sheets suddenly have been freed of the scary bad stuff, and in its place are the ETFs, which produce real income (the dividend). Instantly that shores up their capital and adds to their cash flow, letting them boost their lending elsewhere.

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Later, when the banks can get a good price, they simply sell the ETFs into the broader market, with the 4 percent federal dividend intact. Let’s say investors are willing to pay only 50 cents on the dollar for the full stated value of the ETF; the dividend now amounts to an 8 percent annual return. Who wouldn’t find that sexy? Banks that couldn’t afford a 50 percent haircut would hold on to their ETFs and get those dividends for, say, five years.

And because this is a federal government bailout, let’s make the dividends tax-free.

Plenty of obstacles would have to be overcome, says one ETF designer at a big firm who looked at the Rob Plan. Valuing different pools of assets would be tough. Market makers would need to be able to hedge their ETF positions.

“The arbitrage opportunity is what makes ETFs work, and if you can’t sell the underlying assets, you have no arb,” this guy says. But he adds that, if the ETF were “wrapped” with a U.S. government guarantee of the underlying assets, “you could probably place big chunks of it to other countries like China, and that would form the basis of a market.”

In other words, this idea ain’t so crazy—President Obama and Secretary Geithner should look at it.

“In good times,” says my pal Rob, “the government taxes these (Wall Street) companies. In bad times it needs to help them.” Government “needs tax revenue in the future—and won’t get it if the system implodes.”

He even has conjured up the requisite initialism that has become de rigeueur in these traumatic times: G-SET, for Government-Sponsored ETF. As Rob puts it: “Maybe the government can get some of their money back in the end.”

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